Yet more on stress tests

June 4, 2015June 4, 2015 Michael Reddell Financial stability, Reserve Bank

Two more points on the stress testing issue.

I’ve mentioned a couple of times that someone who was at the Finance and Expenditure Committee hearing on the day of the Financial Stability Report had told me that the Governor deliberately refused to answer a question about the stress tests, and the implications of those results for assessments of the stability of New Zealand’s financial system.

I’m told that the transcript of that hearing is now on the public record, so here is the relevant question and answer. The questioner is National MP Chris Bishop, who is deputy chair of the committee:

Bishop Thanks, Governor. I’m just interested in teasing out what the specific risks to financial stability are for Auckland house prices, because the banking sector has rising capital and liquidity buffers; they exceed the minimums. The banks came through the stress testing pretty well last year. Credit growth is relatively restrained, and as a percentage of GDP, credit is below where it was in 2008-09. So given all that, what are the specific risks to financial stability—which is what we’re discussing here today—from the rising Auckland prices?

Wheeler I think they’re very substantial. I mean, if you look at mortgage commitments, you quoted a number that credit flowing to the housing sector was low. It is on a net basis, but if you look at mortgage commitments, they’re growing at around 20 percent. House prices in Auckland are growing at around 17 percent. They’ve been growing in the rest of the country over the last year at around 2 percent. If you look at house prices to disposable income in Auckland, that ratio is 7.4 percent. But the rest of the country is 4.2 percent. If you look at rental yields in Auckland, they’re at historic lows, which suggests that there’s a lot of people basically investing for capital gain, whereas the rental yields across the country are basically where they have been for the last 10 years.
If you look at the median house price in Auckland, it’s up 60 percent since 2008. We had the highest rate of house price inflation in the OECD from 2003 to 2008. So the median house price in Auckland is now 60 percent above that. If you look at the Demographia survey that was done last year, we were 14^th out of 370 housing markets around the world, in terms of affordability. If you look at the survey that was done by ANZ Bank in terms of investor expectations, late last year, basically, investors in Auckland were forecasting that house prices would increase by 75 percent over the next 5 years. Now, our job is to try and keep inflation, on average, at around 2 percent per annum. So that’s just a phenomenal increase in house prices that are anticipated, and that would just drive house price to disposal income ratios up at a huge rate.

So there’s a whole range of reasons why there are major, I think, financial stability risks around Auckland.

The Governor raised a number of interesting issues, and possible areas of risk, but did not respond to any of Bishop’s points or questions. Now sometimes MPs at select committees can ask questions just to be on record as having asked them, or to make partisan points. And so there is an art in how public servants respond to such questions. But Bishop’s questions and points don’t look as though they fit either of those categories. They seem to be entirely reasonable questions, drawing on the Bank’s own factual material, and yet the Governor simply chose not to engage or respond. That doesn’t seem very wise, or very accountable.

And now, back to some geeky stuff. In discussing the stress tests this morning I mentioned the issue of what size house price fall one might reasonably assume if the stress tests were re-run today. But as someone pointed out, neither I nor the Bank touched on the other factor that is critical in assessing the likelihood of large loan losses, and that is what happens to unemployment.

By and large, falls in house prices alone do not result in large losses for banks. Between with-recourse lending and a general desire to avoid moving (which is costly and disruptive), owner-occupiers don’t tend to default if they can service their debts. Banks can, typically, foreclose if the borrower has negative equity, but are unlikely to do so if the debt is being serviced. Much the same is likely to go for lending for investment properties – if rents are high enough to cover the debt service, banks aren’t likely to foreclose. Foreclosing (itself expensive) crystallises a loss, which might otherwise never happen.

Similarly, high unemployment alone doesn’t typically lead to large loan losses on residential lending. Some individuals will end up losing their houses, but if they have to sell up (or be sold up) the sale price will usually cover most or all of the debt outstanding.

What gets really nasty is the scenario in which house prices fall a long way and unemployment goes up a lot (and stays high for a while). In that scenario, many people can’t service their debts (even if the OCR is cut) and if they have to sell, in many cases the proceeds won’t be large enough to cover the debts.

That is the scenario the Reserve Bank’s stress tests (rightly) focused on. It is the true test of the quality of the residential mortgage loan book.

The Reserve Bank tells us that in the stress test they assumed that the unemployment rate “peaks at just over 13 per cent”. The unemployment rate at present is 5.8 per cent, and the “natural rate” is probably around 5 per cent. The modern low was 3.4 per cent. So 13 per cent is a long way away. In normal times it would take around an 8 percentage point increase in the unemployment rate to get to “just over 13 per cent”.

I was curious how unusual 13 per cent unemployment rates were, so I downloaded the OECD data as far back as it goes. In most cases, that is just over 30 years (but we also know that in most OECD countries the earlier decades were decades of pretty full employment).

Here is the chart of the highest unemployment rates on record for each of the 34 OECD countries. Only 13 of the 34 countries has had an unemployment of 12.5 per cent or above in more than 30 years.

I took a look at those countries. First, I wanted to understand how much the unemployment rate had increased by in each of those country episodes. If the NAIRU in one country had been 10 per cent (perhaps reflecting very restrictive labour market regulation), an increase in the unemployment rate to 13 per cent would have much different implications than if that country’s NAIRU was 6 per cent.

Of the 13 countries whose unemployment rates had peaked at over 12.5 per cent, in one case that peak was the first observation in the database (so I couldn’t tell where the unemployment rate had risen from). Six of the other 12 had had increases in their unemployment rates of 8 percentage points or more (from the previous cyclical low to the measured all-time peak). Thus, for example, Greece’s unemployment rate peaked at 27.8 per cent last year, but had been as low as 7.5 per cent in 2008.

But the other factor I looked at was the exchange rate regime these countries had been using when their unemployment rate rose to 13 per cent or more. In only two of the 13 cases had the exchange rate been floating, and in neither of those cases had the unemployment rates increased by anything like 8 percentage points.

Why do floating exchange rates matter? Simply because they act as a buffer when the economy is hit by severe shocks. Greece, Spain, and Ireland have had very high unemployment rates (and large increases in those rates) in the last few years because they have had no independent national monetary policy, and no ability for their national nominal exchange rates to depreciate. The US, the UK, and Iceland, on the other hand, each having had a nasty financial crisis, had nothing like the extent of those increases in unemployment.

Adjustment is a great deal harder, and more costly, without the additional flexibility the floating exchange rate provides. But New Zealand has had a floating exchange rate for 30 years now, and when the economy has been in serious difficulties the exchange rate has fallen a long way. No one really doubts that the same would happen again if, say, there was a serious recession here that involved the OCR being cut to, or near, zero.

I’m not suggesting that the unemployment rate could not possibly rise by 8 percentage points here. From 1987 to 1991, the unemployment rate did rise by 7 percentage points, to around 11 per cent, even with a floating exchange rate. But that was a pretty stringent test:

Huge amounts of labour-shedding from public and private sector structural reform
A serious domestic financial crisis
And the transitional costs of both lowering inflation markedly, and closing the fiscal deficit, at the same time.

My point is simply to highlight that the Reserve Bank’s stress tests were very stringent, using an increase in the unemployment rate larger than any seen in any floating exchange rate country in at least 30 years. It is right that stress tests are stringent (the point is to test whether the system is robust to pretty extreme shocks) but these ones certainly were. And yet not a single one of big banks lost money in a single year. That might seem a bit optimistic – it did to me when I first saw the results – but they are the Reserve Bank’s own numbers.

And so, again, we are left wondering where is the evidence for the Governor’s latest regulatory initiative?

The Reserve Bank’s stress tests – again

June 4, 2015June 4, 2015 Michael Reddell Financial stability, Reserve Bank

On 13 May, the Reserve Bank released its latest Financial Stability Report. As part of that release, the Governor announced that he intended to impose a ban on (highish LVR) lending secured on Auckland residential investment properties. The Bank indicated that a consultation document on the proposal would be released in “late May”.

The consultation document finally appeared yesterday. I have some fairly extensive comments on the contents of the document, and on the process. I will be making a submission, and will publish that here in due course.

But today I wanted to focus on just one aspect: the place of the stress tests the Bank undertook, with APRA, last year.

As a reminder, the results of the stress tests were reported in the November 2014 FSR (details on pages 9-11 here). The Reserve Bank was, apparently, then very happy with the resilience of the banks (individually and as a system – the latter rather than the former being the required statutory focus). As they noted:

The Reserve Bank’s emphasis tends to be on ensuring that banks have sufficient capital to absorb credit losses before mitigating actions are taken into account. The results of this stress test are reassuring, as they suggest that New Zealand banks would remain resilient, even in the face of a very severe macroeconomic downturn.

As I noted on 13 May, it was somewhat surprising then to find no reference to these stress test results in the latest FSR, even as the Governor was moving to impose very restrictive and intrusive new controls. I suggested that perhaps the Governor did not believe the stress tests. But if so, he owed us an explanation for why, especially in view of the fairly unconditionally positive coverage of the stress test results which he had signed off on in finalising the November report.

I was further puzzled when someone who had attended the Finance and Expenditure Committee hearing on the FSR told me that when the Governor was questioned about the stress test results and their implications for conclusions about the soundness of the financial system, he had simply avoided answering that element of the question.

However, the Reserve Bank then referred to the stress test results in responding to questions to the Herald’s personal finance columnist, Mary Holm. I covered those comments earlier.

On 16 May, there was this extract:

What does the RB think about the possibility of a property plunge. “Whether property prices could drop by half from today’s values is purely speculative,” she says. “Nevertheless, a 50 per cent drop matches some of the more severely affected economies in the global financial crisis such as Ireland.”
So they’re not ruling it out. But would such a drop cause banks to “collapse”? “The short answer is no, we do not believe so,” she says.
“The Reserve Bank conducts regular bank stress tests in collaboration with the Australian Prudential Regulation Authority. The most recent one was last year, and the results of it are featured in the November 2014 Financial Stability Report, pages 9 to 11, on our website.
“This stress-test exercise featured two imagined adverse economic scenarios over five years, one of which involved a sharp slowdown in economic growth in China, which triggered a severe double-dip recession in New Zealand. Among the impacts were house prices declining by 40 per cent nationally, with a more pronounced fall in Auckland – similar to your reader’s worst case scenario.”
So how would our banks fare?
“The Reserve Bank was generally satisfied with how the banks managed their way through the impacts of these scenarios, and we are comfortable that the New Zealand financial system is currently sound and stable, and capable of withstanding a major adverse event.”
Note that present continuous tense in the final sentence: we are comfortable “that the New Zealand financial system is…capable of withstanding a major adverse event”.

That was reassuring, but it did appear inconsistent with proposals for heavy-handed new controls on the other.

And then the following Saturday, we got some more comment from another Bank spokesperson.

“We repeat our comments from last week that the Reserve Bank was generally satisfied with how banks managed their way through the impacts of two adverse economic scenarios in the 2014 bank stress tests, which included a scenario similar to what your reader describes.
“We are comfortable that the New Zealand financial system is capable of withstanding a major adverse event, such as a collapse by up to 50 per cent of the Auckland housing market.”
These words, given to the Herald after the publication of the FSR and published less than two weeks ago, stated quite explicitly that the Bank is “comfortable that the New Zealand financial system is capable of withstanding a major adverse event, such as a collapse by up to 50 per cent of the Auckland housing market”.

And there I half-expected the matter to rest. Since policy development around LVRs seemed to be on a (rather distant) parallel track to stress-testing analysis, I half-expected the consultation document to avoid any mention of the stress-testing results at all, the Bank having reaffirmed only 10 days or so ago the resilience of the system.

But in yesterday’s consultation document, they do address briefly the stress-testing issue. Here is what they say:

The Reserve Bank, in conjunction with the Australian Prudential Regulation Authority, ran stress tests of the New Zealand banking system during 2014. These stress tests featured a significant housing market downturn, concentrated in the Auckland region, as well as a generalised economic downturn. While banks reported generally robust results in these tests, capital ratios fell to within 1 percent of minimum requirements for the system as a whole. Since the scenarios for this test were finalised in early 2014, Auckland house prices have increased by a further 18 percent. Further, the share of lending going to Auckland is increasing, and a greater share of this lending is going to investors. The Reserve Bank’s assessment is that stress test results would be worse if the exercise was repeated now.

First, they note that “capital ratios” in the stress test fell to within 1 per cent [percentage point] of minimum requirements for the system as a whole. But here is how those results were described in the November FSR.

Common equity Tier 1 (CET1) capital ratios declined by around 3 percentage points to a trough of just under 8 percent in each scenario, but remained well above the regulatory minimum of 4.5 percent (figure A3). Banks are also required to maintain a 2.5 percent conservation buffer above all minimum regulatory capital requirements, or else face restrictions on dividends. On average the banking system fell within this buffer ratio in both scenarios, due to total capital ratios falling close to minimum requirements (figure A4). Average buffer ratios reached a low of 1 percent in both scenarios. As a result, some banks would have been faced with restrictions on their ability to issue dividends. The intention of the buffer ratio is to provide a layer of capital that can readily absorb losses during a period of severe stress without undermining the ongoing viability of the bank. Given the severity of the scenarios, capital falling within buffer ratios was an expected outcome.

In other words, the Bank seemed pretty comfortable. As they should have been. A banking system that can withstand a very severe asset market correction and adverse macroeconomic shock with, at worst, “some banks would have been faced with restrictions on their ability to issue dividends”, while all were always above minimum required ratios (themselves calculated using risk weights that are demanding by international standards) is an extremely strong banking system. Plenty of banks abroad raised additional capital during 2008/09 without ever coming close to failure, but not one of the big New Zealand banks ever needed to raise any new capital in these stress test scenarios. But that it is what one would expect when capital buffers are large, and credit to GDP ratios have been going nowhere for seven or eight years.

As the Bank also notes, it is not even that the loan losses in the scenario were large enough to cut into the dollar level of capital banks held: the deterioration in capital ratios arises only because the risk weights on bank loan books rise in the course of the severe downturn. Not a single bank had less capital at the end of the severe stress scenario than at the beginning.

CET1 (tier one, common equity) is the focus of the Bank’s capital framework. Here is the chart from the stress test results.

The Bank also rightly notes that the scenarios for the stress tests were finalised in early 2014 and things have changed since then. Of course, they have not changed materially in the two weeks since the Bank publically reaffirmed the resilience of the system, but let’s put that detail to one side for the moment.

Unfortunately, neither the Bank nor I can easily tell what this set of facts means for the results if the stress tests were to be run today. Auckland house prices have certainly increased a lot in the last year, the share of lending going to Auckland has increased, and a greater share of this (Auckland) lending is going to investors. But other things have changed too – among other things, nominal incomes are higher than they were then, and interest rates look to be lower for longer than the earlier scenario envisaged. Those owing the large accumulated stock of debt (a stock that continues to worry the Bank) have had more time, and more income, to strengthen their own ability to handle adverse shocks.

Perhaps the much higher level of Auckland house prices now suggests that any future stress test scenario should use an even larger fall than the 50 per cent used last year. But 50 per cent is about as large a fall in house prices as has been seen, on any sustained basis, anywhere. If a 50 per cent fall is still a reasonable scenario from the new higher level (as I’d argue it is, given that no one has a good basis for knowing the “equilibrium” level of prices in the presence of ongoing regulatory constraints and policy-fuelled population growth), then all else equal there would be fewer loan losses for banks in an updated test not more.

It is certainly true that a higher share of residential lending is now taking place in Auckland (although I suspect the share of the stock can’t have changed much in one year). In the stress test scenario that would, mechanically, mean a higher level of losses (since the scenario assumed a larger fall in house prices in Auckland than elsewhere). And of the lending in Auckland a little more has been going to investors. But note that final point carefully – as Figure 3 in their consultation document illustrates, the proportion of house sales being made to “multiple property owners” (the proxy for investors) is now no higher than the average in the series since 2008.

The investor property share is higher than previously in Auckland but (a) the difference from the rest of New Zealand is small, and (b) the greater role of investors is partly due to the earlier LVR restriction, which will have forced some first home buyers out of the market, to be replaced by investors. Moreover, in the consultation document the Bank indicates that the earlier LVR restriction has improved the overall “resilience” of the financial system. Even if one believed that lending to investors was riskier than lending to owner-occupiers, all other characteristics of the loan held equal (and the Bank has still not yet persuasively made that case), the overall implications of any changes in portfolio structures over the last year look likely to be small.

Stress tests run today would certainly produce different results to stress tests run a year ago. But housing loan losses have hardly ever been at the heart of a banking crisis, the stock of debt is rising only slowly, and the 2014 results were so strong that it is difficult to believe that the Bank’s analysts are seriously wanting us to believe that stress tests run today would suggest that the financial system was now imperilled. Indeed, I noted the careful way their claim was worded – they suggest that the results today would be “worse”, but not “materially” or “substantially” worse. Given how strong the 2014 results were – as the Bank itself told us – a slight deterioration, in a business so fraught with uncertainty, should not really be a matter of particular concern. Recall that in last year’s tests – an exercise to which the Bank and APRA devoted a lot of resource – not a single bank had a single year of losses. It might sound too good to be true, but it is the Bank’s own work, and “no losses” leaves rather large room for them to be wrong without the soundness of the system being in jeopardy.

Unfortunately, the Bank seems to be all over the place on this issue. It is difficult not to feel some sympathy for the staff who are required to dream up rationalisations, and explain away past robust results, to provide some support for the Governor’s strong pre-determined views. But if they really do believe that stress tests run today would result in a materially greater threat to the financial system then (a) they should probably have steps in train already to raise required levels of bank capital, and (b) it might have been helpful if they made the case in the Financial Stability Report.

Time to reform Reserve Bank governance – domestic public sector perspectives

June 3, 2015June 3, 2015 Michael Reddell Reserve Bank

Yesterday, in discussing my proposition that it is now Time to reform the governance of the Reserve Bank I outlined the contrast between the international perspectives available in the late 1980s when Parliament set up the governance model for the Bank and those available now. Very few countries then central banks (or financial regulatory agencies) that had statutory and effective operational policy independence. There was no international standard that could have been followed. But of the many countries who have reformed their institutions since 1989 not one has followed the New Zealand model. It is very rare for a single unelected individual to have sole legal responsibility for monetary policy decisions, and unknown for one such person to have decision-making authority on both monetary policy and major policy aspects of financial institution regulation and supervision.

Today, I went to look briefly at how New Zealand public sector governance, and conception around it, have changed since 1989. The Reserve Bank is just one among many New Zealand public sector agencies, and it is inevitable, and highly appropriate, that thinking around how to design, manage, and govern other New Zealand public sector agencies should influence how we structure our central bank and financial institution regulatory agency. Huge change took place in the New Zealand public sector in the late 1980s, and the Reserve Bank was somewhat uneasily fitted in to the model.

Back then, the Governor of the Reserve Bank was seen as somewhat akin to a core government CEO. In the reforms of the day, those CEOs were to have performance agreements with ministers, and would be able to be dismissed if they did not achieve the “output” targets specified in those agreements. Departmental CEOs were envisaged as having considerable operational autonomy to achieve these measureable goals.

The state sector has changed considerably since then. For a variety of reasons, departmental chief executives have much less autonomy, and there is much greater emphasis on departments working together, and a recognition that most key decisions rest with ministers. The public service CEO model is not a good guide to how to organise the Reserve Bank, which does have considerable autonomy in policy.

By contrast, the Crown entity model has been developed and systematised subsequently. The numerous Crown entities each perform statutory roles, across a range of types of activities (some more policy-oriented, and others largely just service delivery). But I am not aware of any of these entities in which a chief executive has principal policymaking powers. Rather, key framework decisions are typically made by the board of the respective entity – and members, and the chair, are directly appointed by a minister. The Reserve Bank is not a Crown entity (in the formal central government organisation chart) but as a model for governing agencies that exercise independent authority on behalf of the Crown the approaches used in Crown entities (perhaps especially the “Crown agents” class) seem to be a much more suitable starting point for thinking about governing the Reserve Bank.

In the rest of our system of government, single individuals simply do not exercise the degree of power – without meaningful prospect of appeal or review – that Governor of the Reserve Bank has.

Some extracts from my paper:

As things stood in the late 1980s:

The Reserve Bank was just one of many New Zealand public sector agencies to face far-reaching reforms in the late 1980s.

The governance of government-owned commercial operations had been reformed first (the SOE model came into effect in 1987). For entities operating under the SOE model, the governance was to be very similar to that in a conventional corporate: the Minister appointed Board members, who in turn appointed a CEO to conduct affairs under authority granted to him/her by the Board. For a time, the Treasury had been very interested in the possibility of applying the SOE model to the Bank^{^[1]}.

The State Sector Act 1988 (and the Public Finance Act 1989) dealt with the non-commercial departments. The insights that shaped that legislation were more practically relevant to later discussions around the Reserve Bank.

Under the previous state sector legislation, heads of government departments had permanent appointments – a model which had both significant advantages (as regards free and frank policy advice) and significant disadvantages (all but impossible to get rid of weak performers). The new legislation put chief executives of government departments on fixed term contracts and provided for the establishment of performance agreements between chief executives and the respective ministers. It provided stronger operational autonomy (from Ministers and from the State Services Commission) for chief executives and agencies, and the focus was on being able to hold individuals to account.

A key part of this, at least conceptually, was the attempt at a clear delineation between, on the one hand, the “outputs” of government agencies (things agencies could directly control – e.g. volume and quality of policy advice; hours devoted to traffic patrols etc) and, on the other hand, “outcomes”. Outcomes (e.g. a lower crime rate) were things that politicians and the public probably most cared about. Outcomes were typically affected by the actions of government agencies, but there was no direct and unambiguous mapping between specific actions of agencies and desired “outcomes”. The conception was that CEOs could be held directly accountable for the achievement of output targets that were set by Ministers in performance agreements.

And as things stand now

Some aspects of 1980s public sector reform have proved resilient. The domestic SOE model proved relatively successful for commercial operations owned by government, and relatively enduring, in form as well as in substance. It is becoming less important, particular since the recent wave of partial privatisations, but the proposition that government business activities should be managed commercially, using fairly standard business governance models, has stood up well.

By contrast, in core government departments, the usefulness of the outputs vs outcomes approach as a guiding principle for assignment of responsibilities, and accountability, has probably not lived up to the hopes of the designers. And, not unrelatedly, the degree of effective operational autonomy for (single decision-maker) department chief executives is far less than was probably envisaged by the early advocates of the model. More recently, as a matter of active policy, departmental autonomy now appears to be consciously discouraged, with an emphasis on “whole of government” or “joined-up government” approaches – whether with a view to cost-savings, better policy outcomes, or both.

Much about the way policy is implemented is politically sensitive (i.e. voters expect politicians to be accountable for choices about both “whats” and “hows”). A government concerned to lift educational standards (an outcome) cannot conceivably simply leave to the Secretary of Education the question of whether to adopt, say, a National Standards regime as an “output” in support of the government’s desired “outcome”

As a result, the clean delineation between outcomes and outputs has rarely worked overly well. Government departments still have single (unelected) decision-makers (i.e. their chief executives) but those individuals have little effective independence over outward-facing “how” decisions^{^[2]} (or, increasingly, over key aspects of the internal management of their own agencies).

There have always been many government entities beyond departments and SOEs. Numerous Crown entities exist to carry out a wide variety of public functions^{^[3]}. A consistent framework for these institutions did not exist in the 1980s but in 2004 the Crown Entities Act was passed. It was designed, in Treasury’s words, to “reform the law relating to Crown entities and provide a consistent framework for the establishment, governance and operation of Crown entities. It also clarifies accountability relationships between Crown entities, their board members, their responsible Ministers and the House of Representatives”.

The Reserve Bank is not, formally, a Crown entity, standing in a category of its own in the government organisation chart. There is no obvious reason for that to continue, since there is little obviously unique about the role or functions of the Bank. But the point I wish to make here is simply that, across the wide range of Crown entities (and various sub-categories within that grouping), I am not aware of any case where a chief executive has principal or exclusive decision-making powers Crown entities typically exist to give effect to:

implement some aspect of government policy (e.g. EQC, ACC, FMA, NZQA),

provide advice and/or participate in public debate (e.g. Productivity Commission, Retirement Commission, Law Commission), or

carry out some function government has determined to fund and provide (e.g. NZSO, Te Papa).

In some areas, of course, aspects of the application of policy will shade into policy itself, but matters with pervasive external effects are not simply decided by a CEO. Each of the significant entities I am aware of have a board which has ultimate responsibility for the conduct, and key framework decisions, of the organisation^{^[4]}. Board members, and typically the chair, are directly appointed by Ministers, and each chief executive exercises their delegated power under the direct authority of the respective board.

The practice of collective decision-making (and/or formal review or appeal rights) goes still broader, and is deeply entrenched in our system. Indeed, in New Zealand public life, it is difficult to think of any other position in which the holder wields as much individual power, without practical possibility of appeal^{^[5]}, as the Governor of the Reserve Bank does. Judges, of course, have the power to imprison – but all lower court decisions are subject to appeal, and higher courts sit as a bench, so that no one person’s view alone decides the case. Resource management consent decisions, which hugely and directly affect property rights and values, are subject to appeal. Individual Ministers exercise significant authority, although often requiring the involvement of Cabinet. In New Zealand, all ministers are elected MPs, and any individual minister serves only at the pleasure of the Prime Minister. The Prime Minister, of course, has huge power, but cabinet government is a key feature of our system, and (more hard-headedly) the Prime Minister holds power only while he commands the confidence of his own (elected) caucus. As Kevin Rudd found, that confidence can be withdrawn very quickly.

Typically, public policy decisions that have far-reaching ramifications or that are not customarily made within clear and prescriptive guidelines, are either made collectively, or are subject to appeal, or both. There is nothing comparable in respect of the Reserve Bank.

[1] The ideas are discussed, not entirely impartially, in chapter 5 of the Singleton et al history of the Reserve Bank. Note that at the time there was no formal framework for Crown entities.

[2] Of course “who” decisions (eg on prosecutions, or tax audits, or licenses etc) rightly remain far-removed from Ministers.

[3] http://www.ssc.govt.nz/state_sector_organisations sets out all current state sector organisations.

[4] I have not attempted to work through the entire list of Crown entities to check their respective pieces of legislation, so if there are exceptions I would be happy to be advised of them.

[5] The override powers in Section 12 of the Reserve Bank Act do, of course, provide some scope for acting to deal with a Governor doing rogue things – but are not a routine part of governance (and have never been used). The Reserve Bank can induce, or materially worsen, a recession without significant threat of those powers being used. Perhaps, for example, it did in 1998, during the MCI fiasco.

Who has had the stablest current account of them all?

June 3, 2015June 3, 2015 Michael Reddell Exchange rate regimes, International

I was reading last night a BIS paper from a couple of years ago about the current account experiences (most recently, experiences of surpluses) of China and Germany. Being a data junkie that led me on to the IMF WEO database, looking at the current account experiences of the various economies the IMF classifies as “advanced”. There are 37 of them (but as ever it is a mystery as to how San Marino makes the list, and I ignore them from here on).

The WEO database has current account data back to 1980, although for some of the former communist countries it isn’t available until the early 1990s. The range of experiences is fascinating:
• Largest deficit was 23.2 per cent of GDP (Iceland in 2006, when the aluminium smelters were going in).
• Largest surplus was Singapore in 2007, 26.0 per cent of GDP.
• Only Luxembourg and Taiwan have not run a deficit in any year since 1980
• Only New Zealand and Australia have not once run a surplus in that period.

I was intrigued by the variability (or in many case, lack of it) of the current account balances. The current account balance is often regarded as a buffer, enabling countries to absorb shocks without disrupting a smooth(ish) path of per capita consumption. But here are the standard deviations of the current account balances (as a per cent of GDP) for each of the advanced countries since 1980 (or for the full period for which there is data for each country, but in all cases at least 20 years).

Some of the results surprised me. Australia, in particular, which has had the smallest standard deviation in its current account balances of any of these countries, over 35 years. For a country with a quite volatile terms of trade, and having a massive investment boom in the minerals sector over the last decade, that is quite remarkable. At the other end of the spectrum is Singapore. Singapore’s current account has been becoming much more volatile but the very high standard deviation also partly reflects a structural (but highly distorted) transition from some of the larger current account deficits in the sample, back in early 1980s, to the largest surpluses more recently.

A stable current account deficit is neither obviously good nor obviously bad. It depends on the shocks the particularly economy has faced. And the exchange rate regime plays a part (although of course, the choice of exchange rate regime should depend, at least in part, on the sorts of shocks the economy faces).

Only four of these 36 countries have had a floating exchange rate for the whole period since 1980 – the United States, the United Kingdom, Canada and Japan. All four show up as having had relatively stable current account balances. We could add in Switzerland – with a brief deviation from floating quite recently – and Australia, which has floated since 1983. Five of the six are then among the countries which have had the most stable current accounts, and Switzerland has been around the median. New Zealand’s experience also sits with this stable group, again despite having had some of the most volatile terms of trade of any of the advanced economies.

What about the other end of the spectrum? Of the 10 countries which have had the most volatile current account balances, only Taiwan and Norway now have floating exchange rates. Iceland’s floated freely for a while, but is now managed, as is Singapore’s.

As one would expect, it looks as though in floating exchange rate countries, the exchange rate has reduced the extent of the variability in countries’ current account balances. That isn’t surprising, and it is consistent with formal New Zealand work on how the exchange rate has responded to commodity prices and/or the terms of trade. But it might not always be a desirable feature either. Some shocks will be domestic in nature, and in principle it might be better to absorb them in greater variability in the current account rather than in the exchange rate. And if the terms of trade are volatile, there might also be a case for allowing more of the variability into the current account, rather than immediately seeing the real exchange rate move against producers in all other tradables sectors (eg if dairy prices soar, a higher exchange rate might smooth the effects on dairy farmers, but could greatly complicate life for other tradables sector producers). If the terms of trade shock is lasting, the real exchange rate will rise eventually, but if not then perhaps less variability in the exchange rate might have some advantages.

Simple charts like this don’t lead to policy conclusions. After all, one of the big challenges firms (and households and governments/central banks) face is knowing which shocks are temporary and which are permanent. We need a regime that is robust to our uncertainty about the shocks. And any consideration of a more-fixed exchange rate for New Zealand would run into the complication of the long-term differential between our interest rates and those abroad. (At the extreme, a fixed exchange rate would equalise nominal interest rates, but wouldn’t itself change the conditions that had required the difference in real interest rates in the first place).

I’ve tended to be a defender and advocate of the floating exchange rate regime for New Zealand – not necessarily as a first best option, but as better than any of the feasible (and freedom-respecting) alternatives for the time being. On the whole, I still think that is probably the right conclusion, but I do find it a little surprising, and perhaps a little troubling, that New Zealand has had one of least variable current account balances among advanced economies in the last 35 years. The positive dimension of that is that New Zealand never faced a serious external funding crisis in that time (unlike the Baltics, or Korea, or Greece or Portugal). But it hasn’t exactly been an untroubled time for New Zealand – it is a period that encompasses Think Big, huge swings in fiscal policy, credit booms and one bust, financial crisis, considerable variability in the terms of trade, and so on.

Oh, and this was the chart I first went looking for: There is a loose, but positive, relationship between each country’s average current account balances over 1980-1994 and those now. Countries that had deficits back then tend to have deficits now, and those which had surpluses then tend to have surpluses now.

More on why our interest rates have been so high

June 2, 2015 Michael Reddell Interest rates

Last week I illustrated how much higher our long-term interest rates have been (and are) than those in other advanced countries, and set out my argument that investor concerns about the large New Zealand negative NIIP position (loosely, “the large external debt”) don’t look to have been the culprit.

In this post, I’m going to show another couple of charts, and then briefly respond to a commenter’s question.

One possible reason why New Zealand’s interest rates might sensibly have been higher than those abroad would have been if New Zealand’s rate of productivity growth had been so strong that returns to large amounts of new investment in New Zealand were very high. Profitable business opportunities might have abounded, and businesses had been rushing to invest to take advantage of those opportunities, while households might have been rationally anticipating future much higher incomes.

That doesn’t sound like New Zealand over the last 25 years. In fact, our rate of business investment (as a share of GDP) has been one of the lower among OECD countries. In recent days, I’ve shown a couple of charts drawn from the Conference Board’s TFP data. Here is another. For the advanced countries for which the Conference Board has estimates all the way back, it shows total estimated growth in TFP since 1989 (when the public data start). New Zealand hasn’t been the worst of these countries, but the record is pretty underwhelming. And Greece, Spain and Portugal each look a bit worse than they deserve because there is so much excess capacity in those economies right now.

My other chart this morning is about the slope of the interest rate yield curve. Very broadly speaking, yield curves are generally upward sloping. That is, short-term interest rates tend to average a bit lower than long-term interest rates. But New Zealand has been different.

As I showed the other day, long-term interest rates in New Zealand have been higher than those in other advanced countries. But short-term interest rates have been even higher. That is what this chart captures. It uses OECD interest rate data, The data aren’t ideal: the long-term interest rates are government bond rates, and the short-term rates are those on private sector securities. But as that is so for each of the countries it shouldn’t materially complicate cross-country comparisons.

I’ve deliberately only drawn the chart to the end of 2008. Since the near-zero lower bound on short-term nominal interest rates became an issue for an increasing range of countries, looking at the slope of the yield curve has not had the same meaning (since short-term rates can’t be cut as low as they otherwise would).

Over that 17 year period – in which each country had several interest rate cycles – New Zealand stood out. If foreign investor concerns were at the heart of why interest rates were so high, long-term rates would be high relative to short-term rates (relative to what is seen in other countries). That is the situation in Greece now. But as the chart illustrates, in New Zealand it the other way round. Our short-term interest rates averaged much higher relative to long-term interest rates than was the case in the other countries shown. It suggests that we should be looking for things that drive short-term rates for our explanation as to why New Zealand interest rates have been persistently so high (again, relative to other countries’ rates). It also nicely illustrates my observation the other day that New Zealand interest rates have long been regarded as unsustainably high, and not just by government officials and other pointy-headed analysts. The slope of the yield curve is set in the market. Private investors have expected our short-term interest rates to fall relative to long-term interest rates (whereas in these other countries there was no such expectation). But those expectations have been wrong. Persistent surprises in how long our interest rates have stayed up relative to those abroad can help explain why the exchange rate has been so persistently strong. My former colleague, Anella Munro, covered some of this ground, in rather more technical terms, here.

And finally, some brief answers to a commenter’s question. On Friday a commenter asked:

Michael, your analysis seems to make sense – that it’s more pressure on resources than risk premium that explains persistently high NZD interest rates
But it also raises, for me, some further questions.

My understanding is that when the NZ Government used to borrow in USD, back in the 1970s and 1980s,(when NZ was probably a worse credit risk than it is today), it did so at a rate only a small margin above the rate at which the US government borrowed. And I imagine that, today, NZ banks borrow USD at much the same rate as that at which US banks borrow. So if the only difference is in the currency of denomination (ie, the counterparties and the countries are the same) doesn’t that suggest that the explanation for the persistently high NZ interest rate has to have something to do with the currency?

Second, if there has been persistent pressure on resources, why would that not have been been closed by net imports?

Grateful for any responses you may be able to offer.

On the first question, yes New Zealand credits borrow internationally in USD at much the same interest rates as similarly-rated borrowers from other countries do. A AA-rated New Zealand bank is likely to pay much the same US interest rate on a bond issue as, say, a AA-rated Swedish bank might. That certainly helps make the point that, whatever, is accounting for the differences between, say, New Zealand dollar and Swedish krone interest rates it is not the credit quality of the borrowers. The credit ratings of our banks are as good as those anywhere.

But does that mean that it is all to do with the exchange rate? Well, yes and no. I would argue that it is the ability of the exchange rate to move that makes the material cross-country differences in interest rates possible[1]. Since expected risk-adjusted returns should be roughly equal across advanced countries, interest rates on New Zealand dollar assets can only be higher than those on assets denominated in another currency (for similar quality borrowes) for any length of time, if the New Zealand dollar is expected to depreciate against that currency over time. When the interest rate gap opens up, the New Zealand dollar tends to rise until it reaches a level that is not regarded as sustainable. At that point, the expected future deprecation more or less offsets the yield advantages. There is an alternative story, in which the NZD is such a volatile currency that we have to pay premium interest rates to attract the foreign capital we need. But again, if such premia exist, and are material, they should result in a surprisingly weak exchange rate. That hasn’t been the New Zealand story – indeed, the only sustained period of weakness in the New Zealand exchange rate was around the turn of the century when our policy rate was quite low relative to those abroad (our OCR briefly matched the Fed funds target rate in 2000). Such premia – whether to do with the NIIP or a volatile exchange rate – should tend to encourage resource-switching towards the tradables sector, in a (self-stabilising) manner that reduces future perceived vulnerability and any risk premia. I scarcely need to point out that we’ve seen nothing of that sort over 25 years.

And just briefly, the second question was whether, if there has been persistent pressure on resources, why that would not have been closed by (net) imports. The simple answer to that is because the economy can be thought of as made up of tradable bits and non-tradable bits. If everything in the economy were fully tradable, then any excess demand in New Zealand could be expected to be fully met through imports. Since tradables prices are set largely in world markets, there would be no sustained domestic pressures on the inflation rate (and no real need for a domestic monetary policy, or our own currency). Most of the interesting stuff arises from the fact that much of the economy is not freely tradable across borders, and tradables and non-tradables aren’t fully substitutable (I need a haircut, my mother needs rest-home care, and so on). So when we see persistent incipient excess demand pressures, some of the pressure shows up in the current account, and some in interest rates. As a result, despite a pretty strong government balance sheet, New Zealanders’ have run large current account deficits over the last 25 years, and we have had high interest rates relative to those in other advanced countries. Excess demand pressures, arising domestically, largely explain both phenomena.

[1] As I illustrated in one of my very early posts, back in the 1890s, when the New Zealand government was very heavily indebted, but the exchange rate was fixed, the gaps between New Zealand and UK government bond yields were much smaller than those in recent decades.

TFP growth in commodity-exporting countries

June 1, 2015June 2, 2015 Michael Reddell Productivity

On Friday, I took the Conference Board’s productivity data and looked at how New Zealand had done on TFP growth relative to other advanced countries since 2007. “Not that well” was the short answer.

The disappointing performance does need to be kept in some perspective. New Zealand’s productivity growth has been disappointing for a long time. The Conference Board publishes TFP data only back to 1989. However, a couple of years ago, some IMF researchers were given access to some unpublished Conference Board TFP data back to 1970. Of the countries they looked at New Zealand had had the slowest TFP growth over the full period 1970 to 2007, and had grown more slowly than the median country in each of the four sub-periods they looked at.

Against that background, our slower than median TFP growth since 2007 perhaps looks slightly less discouraging (not much less, given the decades of underperformance we might one day hope to start reversing).

As I noted on Friday, we had done a little better since 2007 than some of the other commodity-exporting advanced countries. Commodity-exporting advanced countries have all had negative TFP growth over the last decade or so. This chart shows TFP indexed to 100 in 1989 for each of the six commodity-exporting advanced (ie OECD member) countries. Over 25 years, not one of them has recorded any material TFP growth (on this particular measure of TFP). As ever, Mexico is the basket case.

Weak TFP growth is not always and everywhere bad. High commodity prices encourage producers of commodities to adopt different profit-maximising production techniques. For example, poorer ore grades become economic to mine, but to do so takes more inputs. That shows up as a fall in TFP, but presumably an increase in industry profitability. In addition, massive investment programmes (as in Australia) to take advantage of high commodity prices do not boost output in the short-term (a project can take years to put in place), but involve the application of more resources to the industry. That will also show up as lower TFP. What about New Zealand? We have not seen a business investment boom in response to the stronger terms of trade, but the dairy industry has altered its production processes, with more supplementary being used to produce more milk per cow. Those choices were profitable, and sensible from the farmer’s perspective, but at the margin they involve using more inputs for each additional unit of output. That shows up as a fall in TFP.

Quite how much these factors explain is debated , and requires a much more in-depth analysis of the national data to answer with any confidence. But in New Zealand’s case, TFP is agriculture had flattened off well before the rise in the terms of trade, which didn’t really begin until around 2004.

Time to reform the governance of the Reserve Bank

May 30, 2015May 31, 2015 Michael Reddell Reserve Bank

[Here is the link to the coverage of my paper on governance in the Sunday Star Times]

This post had its origins in an earlier OIA stoush – not mine, but that of one of the Green Party’s parliamentary staff.

For at least 15 years, I’ve thought that the way the Reserve Bank was governed should be changed and that we should move away from the situation (unusual internationally and anywhere else in the New Zealand public sector) where a single unelected official makes all the policy decisions (in the Reserve Bank case, on monetary policy and financial regulatory matters). Other countries don’t do it that way. New Zealand doesn’t do it in any other field of policy.

In late 2011, I was filling in time in the office between Christmas and New Year. Alan Bollard’s second term was coming to an end, and while he hadn’t confirmed he was going it was widely (and correctly) expected. I’d been saying to people for some time that a change of Governor was the best time to try to trigger discussion on the issue. So I decided to write a brief internal discussion note making, in writing, the case I’d been making in conversation for years. I didn’t propose a detailed alternative model, and simply urged that change be considered, and that the Bank think about getting in front of the issue. I wrote the note, and sent it round to only perhaps 10-12 of the Governor’s senior advisers on monetary policy. I went on holiday, and when I got back word came down that the Governor was not all happy that the discussion note had been written.

Some months later, I took the opportunity to revise the note, and to take on board some useful comments I had received. By this time, it was confirmed that Alan Bollard was going, but no decision had quite yet been announced as to who would be the new Governor. Since no one could then think the paper was in any way a criticism of any individual, I sent it around a wider group of the Bank’s policy and analytical staff. When Graeme Wheeler joined the Bank I sent him a copy, and had an appreciative response.

At some stage in 2013, the Green Party became aware that the paper existed (because the Bank had released another paper under the OIA, and my note was included in the list of references). Their staffer asked for the paper, and was turned down. He pursued the matter to the Ombudsman, who accepted the Governor’s argument that if this paper were released he would not be able to allow free and frank debate among staff. I didn’t have a strong view on whether it should be released – internal debate is important, and my note had been intended only as a contribution to that. But it wasn’t a very recent paper, hadn’t even been written when the current Governor was in office, was not on a topic that was under active review, and the Governor’s argumentation was perhaps a little chilling.

Anyway, had the 2012 paper been released a couple of years ago, I probably wouldn’t have done anything more on the issue. But I had continued to think about the issues, and particularly to think about them in the context of the much wider ranges of responsibilities and powers the Bank now exercises. The result is this paper.

time for Parliament to reform the governance of the Reserve Bank online version

My preamble is partly to make clear that this is an issue that I have been thinking about for a very long time. As people occasionally remind me, some of my comments on this blog could be seen as (but are not) motivated by grudges against current Bank management. As Don Brash will confirm, I was running (less-developed forms of) the argument fifteen years ago. The best Governor in the world simply should not have the extent of power any Reserve Bank Governor now has.

As important are two things:

The Reserve Bank does not write its legislation, Parliament does. The Bank, and its Governor, operate within laws that Parliament has passed. The responsibility for legislation in this area rests with the Minister of Finance and Parliament.
To his credit, Graeme Wheeler seems to have recognised some of the weaknesses of the current system. I suspect he and I would not agree on the solution (I don’t think staff should make the sorts of decisions the Reserve Bank is responsible for), but what matters at this stage is to get a good discussion and debate going, and to have a careful examination of the pros and cons of various possible models.

As it happens, I’m not sure if anyone is now particularly wedded to the current model. The Treasury favoured a review in 2012, and they reported that many or most of the market economists then favoured change. The Governor appears to recognise the risks and deficiencies of the single decision-maker model, and several political parties have also at times talked of proposing change.

This isn’t an issue that should divide people on any sort of ideological lines. I’ve taken as given the current powers and objectives of the Bank. Perhaps some of them should be looked at again, but this paper is just an attempt to prompt some discussion about how best to organise and govern a powerful New Zealand public agency, carrying out the wide range of functions that Parliament has assigned to it.

As ever, I’d welcome thoughtful comments and alternative perspectives.

The first page of the paper, an introduction and summary, is here:

Introduction and summary

When Parliament passed the new Reserve Bank of New Zealand Act in December 1989 a key, and innovative, feature of the Act was that the powers of the Reserve Bank were to be exercised by the Governor, and the Governor alone. The legislation provided substantial operating autonomy to the Reserve Bank, and the establishment of a single decision-maker was seen as a way of providing effective accountability. If things went wrong, the Governor would have been responsible for any decisions, and the Governor could be dismissed, for cause, by the Minister of Finance.

But the model is out of step and out of date. It is out of step with international practice in respect of monetary policy and of financial system supervisory and regulatory policy. As importantly, it is out of step with approaches to governance used in the New Zealand public sector more generally.

The Reserve Bank governance model was developed, in part, to parallel reforms to core government departments that were going on at much the same time. Those reforms themselves have since been considerably modified. But even if that were not so, the conception of the Reserve Bank that the 1989 legislation reflected has not been borne out by reality.

The 1989 governance model might have been thought appropriate (if still unusual) for a very simple and uncontroversial most-monetary-policy agency. Today’s Reserve Bank is a complex, multi-functional, organisation, exercising much more policy discretion in a range of areas, that are all characterised by considerable risk and uncertainty, than was envisaged in the 1980s. Vesting all that power in a single unelected person is too risky, and is inappropriate. It is not the way we do things in New Zealand.

In this note I will take as given both the range of functions the Reserve Bank has, and the allocation of powers between the Minister of Finance and the Bank. Aspects of both issues should probably be revisited, but here I focus simply on the weaknesses in the governance model given the responsibilities that Parliament has assigned to the Reserve Bank.

The rest of this note outlines the key aspects of Reserve Bank governance and explains the background to the governance choices made in the 1989 Act. It then focuses on how different things are today and why, even if it was a suitable model in 1989, it no longer is today. I outline some alternative options and conclude by outlining my own preferred option. Key aspects of any reforms should be (a) a move away from having policy decisions made by a single unelected official, and (b) the establishment of collective decision-making bodies which clearly distinguish among the main functions the Reserve Bank undertakes.

Compulsory enrolment in Kiwisaver

May 30, 2015May 30, 2015 Michael Reddell Savings

I’m puzzled.

Fresh from removing the sign-on bonus for new KiwiSaver members, Bill English is now talking about compulsorily enrolling everyone (well, all employees I assume) in KIwiSaver. This was National Party policy to do at some stage, when the government’s books were in surplus, but it has now got cheaper to do because people could now be forced to join, at no upfront cost to the government.

It is far from clear what problem the Minister of Finance thinks he would be addressing. Everyone who has started a new job since 2007 has already been auto-enrolled, and many others have chosen to enrol. My guess would be that at least half of those who were in labour force in 2007 have changed job since then, and a large number have entered the labour force for the first time. All those people were auto-enrolled. Most of those who have never joined, or have opted out, or subsequently taken a contribution holiday, have presumably made a considered choice. Perhaps they can’t afford to be in the scheme now. Perhaps paying off the mortgage is a higher priority. Perhaps they are among that large group for whom NZS will already more or less maintain their pre-retirement standard of living.

I had hoped that the government might now leave KiwiSaver to wither on the vine. After all, there is not much evidence that the scheme so far has boosted national savings, and there isn’t an elderly poverty problem. Enhancing the retirement income of the relatively comfortable doesn’t seem like an obvious public policy priority.

The Minister did once regard New Zealand’s relatively low rate of national savings as a problem, but Google throws up no references along those lines in the last 3-4 years. If he no longer regards national savings as a policy problem, I happen to agree with him (I’ll get to savings as I carry on discussing the reasons behind NZ’s high interest rates).

Surely provision for retirement savings can’t be the problem either? After all, this government has ruled out any change to the age of eligibility to NZS, and if they have not ruled out lowering the rate or means-testing they have certainly shown no appetite for doing anything. And, as is well-known, New Zealand’s rate of poverty among the elderly is low, absolutely and by comparison with other countries. Of course, high house prices may make that picture less rosy in a few decades’ time, but the government knows that freeing-up housing supply is the answer to that one.

And, in any case, although it is proposed to auto-enrol all employees, they could still choose to opt out. Indeed, given that it is almost exclusively people now over 25 who have not been auto-enrolled already, one might reasonably assume that a large proportion of those who would be compulsorily enrolled if the Minister’s proposal went ahead might choose to opt out. Yes, I know all the “nudge” literature, but recall that this experiment would not be on the population as a whole, but on a self-selected group of whom many had already deliberately chosen not to join.

And if income adequacy in retirement were really the concern, surely (a) compulsory contributory membership (not just initial enrolment), and (b) something that encompassed the whole population (business owners, welfare beneficiaries, stay-at-home parents) not just employees, would be the way to go. But, fortunately, that doesn’t seem in prospect.

The National Party’s website says that it believes as follows:

The National Party seeks a safe, prosperous, and successful New Zealand that creates opportunities for all New Zealanders to reach their personal goals and dreams.

We believe this will be achieved by building a society based on the following values:

Loyalty to our country, its democratic principles, and our Sovereign as Head of State

National and personal security

Equal citizenship and equal opportunity

Individual freedom and choice

Personal responsibility

Competitive enterprise and reward for achievement

Limited government

Strong families and caring communities

Sustainable development of our environment

At least three of those values – “individual freedom and choice”, “personal responsibility”, and “limited government” look inconsistent with auto-enrolling everyone in KiwiSaver. Perhaps they might justify it under “personal security”, but I’d assumed that has to do with crime, and anyway, as noted already, elderly poverty just is not a major problem in New Zealand.

Compulsory enrolment of all employees in KiwiSaver smacks of something from The Treasury, and its “living standards framework”. But last time I looked, that framework put no independent value on things like individual freedom and choice, except insofar as they served some other end.

The Minister also appears to be using the dubious argument that Kiwisaver is an excellent investment. If it were really so, you would think that after eight years most people might have got the idea. But in fact, it is true only on very shaky assumptions. Certainly, for the time being there is an annual government subsidy of up to about $500. That is worth having, but it is hardly transformative. In fact, for most people with a mortgage and contributing to Kiwisaver, it won’t even cover the tax wedge. So the Minister’s claim is true only if the employer’s contribution to Kiwisaver would not otherwise be paid to the employee. In the short-term, for any particular job or employee that might be true – that (and the subsidies) was the main reason I joined Kiwisaver. But in the medium to long-term surely the Minister of Finance does not believe that returns to labour will be materially affected by whether people take their income in the form of Kiwisaver contributions or in straight wages and salaries?

So New Zealand

Does not have a national savings policy problem (although the national savings rate does raise some interesting questions)
Has little or no evidence that KiwiSaver so far has made any material difference to national savings anyway
Does not have an elderly poverty problem
Has a government which is firmly committed to the current NZS system.
Has most people already in KiwiSaver, while those in the workforce who aren’t in KiwiSaver will already mostly have made an active choice to stay outside.
Has a governing party that proclaims commitment to personal responsibility and individual freedom and choice.

And for most people in their middle years, Kiwisaver involves a very nasty tax wedge.

So quite why would the Minister of Finance think it was good policy to compulsorily enrol the rest of the employees in the country in KiwiSaver?

If it is almost everything, we really haven’t done well

May 29, 2015May 29, 2015 Michael Reddell Productivity

The old line is that if productivity isn’t everything (about economic performance) it is almost everything in the long run. And multi-factor productivity (or total factor productivity) is typically seen as the best type of productivity (ie not just throwing more inputs into production, but getting more from them). At least, that is, when it is not just measurement error (and there is inevitably some of that).

In the last few days the Conference Board released the annual update of its productivity estimates. The Conference Board data are really useful because they use a common methodology across a very wide range of countries. There might be better estimates for many individual countries in national data, but there are valuable insights in cross-country comparisons. Many of you may have seen the Financial Times feature on productivity a few days ago (it is reprinted in today’s Herald)

I’ve only had a quick look at the latest data. For cross-country comparisons, when I can I like to cast the net widely and capture as many advanced countries as possible. In this case, I’ve taken all EU countries, all OECD countries, and added Singapore and Taiwan. That gives a good range of advanced countries both richer and poorer than New Zealand, and a reasonable number of commodity exporters too.

This chart just looks at MFP growth since 2007, in other words since just before the global recession. MFP growth has been lousy over that period – only a small number of these countries recorded any growth at all. In fact, MFP had been slowing even before the recession, but here I was just interested in the cross-country perspective: who did relatively well, and who did relatively badly.

As you can see, New Zealand has not done not very well – we are in the lower half of the sample. On the other hand, we did do better than most of the other commodity-exporting countries (beating Australia, Norway, Chile and Mexico). The thing that struck me in looking at last year’s version of the chart was how relatively well the United States had done. The US had been at the epicentre of the initial crisis, and had had multiple failures of financial institutions and disruptions to the intermediation process. And yet, over these seven years, only six countries did better than the US. A little surprisingly, half the countries in the euro did better than New Zealand on this measure (although not on actual GDP per capita)

I’ll be writing more on some of this data over the next few weeks. I’ve been intrigued for some time as to why New Zealand, which has had such a good terms of trade, and had no serious home-grown financial crisis has not done better over the last few years.

Can the foreign debt explain New Zealand interest rates?

May 29, 2015May 29, 2015 Michael Reddell Interest rates

(This is a long post. The short answer is “no”.)

Yesterday I showed that the gap between New Zealand real and nominal interest rates and those in other advanced economies has been large for a long time..

There is quite a bit of debate about why. I want to deal quite quickly with several stories that have been run at times:

Some argued that high interest rates are mostly down to monetary policy. But even if monetary policy is a bit tight right now, over the last 25 years as a whole inflation has averaged a bit above the midpoint of the successive inflation target ranges. And if the early inflation target was low by international standards, at least since 2002 a target centred on 2 per cent has been very internationally conventional. Monetary policy isn’t the answer. .
Some have argued that a small country would almost inevitably have higher interest rates (all else equal) than countries with lots of public debt on issue (eg the US, Germany, Japan, or Italy). Perhaps, but in the data any effect of this sort looks to be very small – Sweden has borrowed at much the same rates as the United States, and New Zealand’s bond yields have also been well above those of the typical small, floating exchange rate, advanced country.
For a while it was suggested that our nominal bond yields were higher than those abroad because people were less confident that low inflation would last than they were in other countries. But there is no external evidence to support the idea. And although we don’t have long time series of inflation indexed bond yields, what data there are suggest that real interest rates here have been well above those in other advanced economies.

These days the main debate is between a story (which I think the Reserve Bank generally agrees with) in which domestic resource pressures explain our interest rates, and one in which high New Zealand interest rates reflect the high level of net international liabilities owed by New Zealand resident entities. Today I want to explain why I find the latter story unpersuasive.

The story goes that international investors look at the stock of debt, worry about the risk that it poses, and charge New Zealand (dollar) borrowers higher interest rates accordingly. There are number of possible lines of argument:

The direct one just mentioned: high debt means high risk, and lenders charge a premium (just as a bank might charge more to a highly leveraged borrower)
A story based on incomplete mobility of capital. According to this story, we can borrow a great deal of money at “the world interest rate”, but our high NIIP means we run up against the limits of the number of investors who might be interested in having New Zealand exposures, and the net effect is a higher cost of credit at the margin.
A story based around exchange rate crisis risk. In this story, it isn’t the debt itself that is necessarily risky (and the evidence is that highly rated NZ USD borrowers haven’t typically paid much more for debt than similar US USD borrowers) but rather NZD-denominated debt, because of the exchange rate risk. Specifically, even if the New Zealand dollar trades pretty normally in normal times, a country with lots of foreign debt is exposed to considerable rollover risk. In times of crisis, the exchange rate could fall a very long way. To compensate themselves for this risk of a NZD foreign exchange crisis, investors demand a higher return on NZD assets than they would on comparable assets issued in the currency of a less indebted country.

In the abstract, these can sound like plausible stories. And there certainly have been cases of countries with very high levels of debt where yields have sky-rocketed, or who have even been cut out of funding markets altogether. The risk of being cut off by funding markets played on the minds of New Zealand policymakers for decades, dating back to the 19^th century.

But I don’t think these risk premia stories (which is how I will collectively describe them) can really explain what has gone on in New Zealand in recent decades.

Is there, for example, any sign that investors and offshore lenders have been particularly concerned about New Zealand’s international investment position?

The short answer is “not really”. And that shouldn’t really be surprising. By international standards, the net international investment position of New Zealand is quite large, at around 70 per cent of annual GDP. Historically, it has swung through huge ranges – probably nearer 200 per cent at peak in the late 19^th century, and perhaps only around 5-10 per cent of GDP in the early 1970s. The net external liabilities ran up rapidly in the late 1970s and early-mid 1980s. That mostly reflected the very substantial increase in public debt that occurred at the same time. New Zealand’s historical statistics aren’t good, but the points in the previous two sentences aren’t really contentious.

But what is sometimes forgotten is that the net international investment position (as a share of GDP) has now been basically flat for 25 years. Here is the chart, with data as far back as the official SNZ series goes. The NIIP wobbles around a bit, and is a bit lower than usual at present on account of all the reinsurance claims that crystallised following the Canterbury earthquakes, but has not gone anywhere for 25 years.

In itself, that is interesting, because public debt has changed a lot. In the late 1980s, net public debt was large, and one could think of the NIIP position as being largely accounted for by the government’s debt (large operating deficits over too many years, and the Think Big debacle). Foreign lenders might have been a bit worried, and there were some signs of that: the threat of a double downgrade, and Ruth Richardson’s hasty trip to New York to fend off that threat.

But government debt subsequently fell steadily for 15 years, and one year the government even had slightly positive net assets (this is data from the Treasury’s long-term tables). Debt has certainly increased a little over the last few years, but there is no sign from anyone (investors, rating agencies etc) that our public debt is a concern. It isn’t the lowest in the advanced world, but it is towards the lower end of the range.

But as government debt shrank, private borrowing moved in to take its place. By contrast, in Canada when the government got on top of its fiscal problems – impelled in part by a crisis of investor concerns around Quebec – in the mid 1990s, the reduction in public debt was matched by a significant reduction in Canada’s (then) large net international investment liabilities.

The fact that our net international investment position has stayed large and negative, even as the government finances have been put into pretty good shape is one straw in the wind suggest that our interest rates aren’t high because of worried foreign investors. When lenders got worried about the financial health of borrowers, and increase the cost of finance accordingly, rational borrowers tend to wind back their debt. Corporates do it. Households do it. Governments do it. New Zealand didn’t.

The other straw in the wind is that the exchange rate has stayed persistently high. To be sure, it has gone through quite large cycles, and people can debate whether it is “overvalued” or not, but I’m pretty sure I’ve not heard anyone argue that the NZD has been consistently undervalued over the last 25 years. The much more common line has been to note how high the exchange rate has been, and to think that it really needs to go down. That has been a line from the IMF and from domestic officials. And it shows up in things like Cline and Williamson’s fundamental exchange rate estimates, which have consistently suggested that the NZD has been one of the most overvalued currencies in the world.

Academic papers often model the effect of investor concerns by adding a term (a “risk premium”)to the interest rate. They do so largely for reasons for analytical tractability. In fact, overseas investors have no way of adding a premium to New Zealand’s short-term interest rates. The Reserve Bank sets the OCR, based on domestic pressures on local resources. Foreign lenders getting concerned about the level of debt New Zealand entities have doesn’t increase resource pressures. If anything, such concerns might diminish resource pressures a little (eg a bit less greenfields foreign investment).

Long-term bond yields are freely traded. We saw that yesterday in the spike in the yields some of the European crisis countries faced in 2011 and 2012. But over 25 years, the gap between New Zealand and foreign long-term interest rates has been less than gap between New Zealand and foreign short-term rates. Again, it doesn’t suggest some unusual risk premium related to the high level of NZ’s external debt.

Of course, the interest rate is not the whole of the foreign investor’s return. A foreign lender buying a New Zealand government bond outright has to think about two factors: the interest rate on the bond, but also the change in the exchange rate between when he purchases the bond and when he finally sells it and repatriates his money. The investor doesn’t know how much the exchange rate will change, but he needs to form an expectation (actual or implicit).

Long-term interest rates are largely determined by expected short-term interest rates, and short-term interest rates are largely determined by domestic pressures on resources. But nothing of that sort anchors the level of the spot exchange rate. Foreign lenders don’t need to purchase, or hold, New Zealand dollar bonds. If they were ever to become particularly concerned about New Zealand they might look to sell, or reduce their purchases, of New Zealand dollar assets. That selling might raise domestic bond yields a little, but it would certainly be expected to lower the exchange rate. In an economy with heightened investor concerns and a floating exchange rate, the exchange rate would be expected to fall to the point where the combination of the interest rate on the domestic bond and the expected future appreciation in the exchange rate together provide sufficient return to cover the investor’s perception of risk[1].

If this all seems a little odd to readers, think of a parallel with equity markets. If investors become concerned about the risks on an individual share or on the market as a whole, they will want a higher return to compensate themselves for that risk. The typical response is not to demand higher dividends (which could be thought of as parallel to a higher interest rate on a debt instrument). Even if corporate boards agreed, higher dividends would be only likely to further weaken the companies’ financial positions. The operating businesses can’t readily usually quickly generate more cash-flow – indeed, if they could the concerns probably would not have arisen in the first place. Instead, what typically happens is that the share price falls (the “equity risk premium” is said to rise). How far do share prices fall? Well ,they need to fall far enough that in combination the dividends and the expected future increase in the share price together provide enough return to investors for them to be comfortable continuing to own the shares.

In a similar way, a country which lenders regarded as having too much debt for comfort, and from which they wanted a higher return, would tend to be a country with a weak exchange rate not a strong one.

As I put it in a paper a couple of years ago:

If sustained heightened external investor concerns about the New Zealand NIIP position had ever developed they would, most probably, have been reflected in a sustained period of exchange rate weakness. And an adjustment of this sort would have been an example of self-stabilising properties of the economy at work. A fall in the exchange rate provides the signal that shifts resources away from meeting domestic demand, towards (net) production for exports. That shift of resources in turn and over time reduces the build-up of net external liabilities, lowering the NIIP/GDP ratio back towards some more comfortable/sustainable/normal level. As the NIIP ratio returns to a more comfortable level, foreign investor concerns should ease expected required returns would fall, and the exchange rate might be expected to recover some ground.

We have seen no sign of that sort of pressure on any sustained basis at any time since at least the early 1990s. If anything, the concern at times was around over-exuberant capital inflows. There is no sign that external investor concerns have driven our interest rate differentials. Instead, it is the domestic pressures on resources, generated by firms, households and governments savings and investment choices that explain most of it.

Of course, persistently high New Zealand interest rates don’t mean there is a free lunch on offer to foreign investors. Recall that an investor’s total return is the interest rate on the New Zealand dollar asset, and the change in the exchange rate. When interest rates here look particularly attractive to foreign investors, the exchange rate tends to rise to the point where the expected future depreciation just offsets the additional returns on the NZD security. The critical word in that sentence is “expected”. Expectations drive behaviour. In New Zealand’s case, a lot of expectations have been consistently misplaced. Over a long period, investors have expected the gap between New Zealand and foreign yields to close. And it hasn’t – not on any sustained basis anyway. And when our interest rates got particularly high, investors have usually expected the exchange rate to depreciate before too long, and invested accordingly. Ex post, people buying and holding New Zealand dollar assets look to received windfall high returns, but in fact they took a great deal of risk to secure them. Had the market’s expectations about interest rate convergence come right, they would have ended up not consistently better off than if they had kept their money at home.

So my argument is that New Zealand interest rates have averaged so much higher than those abroad because of domestic resource pressures. Those on-going pressures have helped keep the NIIP position large (unlike Canada). The nature of those pressures is not that well understood (probably why markets have been persistently surprised). Before too long, I’ll do a post or two looking at some of the factors that might lie behind those surprisingly strong pressures.

In the meantime, I covered this material on pages 42 and 43 of this paper (which also has the references to various papers that make the risk premium case). The paper itself outlines the resource pressure arguments more fully.

But the key point to take away is that stories about investor concerns imply a low exchange rate, perhaps puzzlingly low from a New Zealand perspective, not a high one. Don’t take my word for it – as Charles Engel, one of the leading scholars in the field. put it “a currency whose assets are perceived to be risky….should be weaker ceteris paribus”.

Perhaps we would have seen that sort of pressure in the late 1970s and early 1980s if we had had an open capital account and a floating exchange rate. But we’ve seen nothing of the sort, for any prolonged period, in the last 25 years.

[1] It is different in a fixed exchange rate country (such as the eurozone countries in the 2011/12 crisis) where the pressure must go into domestic interest rates. But New Zealand has long had a floating exchange rate.

croaking cassandra

Economics, public policy, monetary policy, financial regulation, with a New Zealand perspective